The ‘official’ cost of austerity

Well, not quite, but probably as close as we will ever get.[1] In a new paper, Jan in‘t Veld uses the European Commission’s QUEST model to estimate the impact of fiscal consolidation in the Eurozone (EZ) from 2011 to 2013. The numbers in the table below include spillover effects from other EZ country fiscal consolidations, so they are best interpreted as the impact of overall EZ fiscal consolidation over this period. There are at least two important things to note about the exercise. First, they do not attempt to analyse the impact of the particular mix between cuts in spending and increases in taxes applied in each country. Instead the ‘input’ is simply the change in the general government primary structural balance each year, which is assumed to be equally balanced between expenditure and revenue measures. (More on this below.) Second, to a first approximation this fiscal consolidation is assumed to lead to no change in short or long term real interest rates during the 2011-13 period.

Of course many would argue that had countries like Spain or Greece not undertaken this degree of austerity, long term interest rates might have been even higher than they actually were. (Perhaps short rates might have also been higher, if with stronger growth the ECB had raised short rates, but remember that tax increases also helped raise EZ inflation.) However a significant amount of fiscal consolidation took place in Germany, and this had significant spillover effects on other EZ countries. It is difficult to see why that consolidation was required to ease funding pressures.

One slightly surprising aspect of the exercise has already been noted. To quote: “As detailed information about the composition of the actual consolidations is not available, it is assumed the composition is equally balanced between expenditure and revenue measures.” As other institutions like the IMF publish exactly that kind of information, I’m puzzled. What the paper does report is that QUEST shows that consolidation implemented through spending cuts has about twice the short run multiplier as consolidation through higher taxes, but of course this is exactly what theory would suggest. In a forward looking model like this it also matters a great deal how agents perceive the permanence of these policy changes.

Of course QUEST is just one DSGE model, which just happens to be maintained by the Commission. An earlier study (pdf) by Holland and Portes at NIESR had important differences in detail, but the bottom line was similar: EZ GDP was 4% lower in 2013, and the cumulated GDP loss was 8.6%. These numbers are of course large, and so it is quite reasonable to say that the proximate cause of the second EZ recession is simply austerity.

Now many would argue that much of this was forced by the 2010 crisis. There seems to be a mood of fatalism among many in Europe that this was all largely unavoidable. I think that is quite wrong. Some fiscal tightening in Greece was inevitable, but if EZ policy makers had taken a much more realistic view about how much debt had to be written off, we could have avoided the current disaster. What ended the EZ crisis was not austerity but OMT: if that had been rolled out in 2010 rather than 2012, other periphery countries could also have adjusted more gradually. And of course fiscal consolidation in Germany and some other core countries was not required at all. If instead we had seen fiscal expansion there, to counter the problem of hitting the ZLB, then the overall impact of fiscal policy on EZ GDP need not have been negative. (Section 5 of Jan in‘t Veld’s paper looks at the impact of such a stimulus.) That means that over 3 years nearly 10% of Eurozone GDP has been needlessly lost through mistakes in policy. This is not the wild claim of a mad macroeconomist, but what simple analysis backed up by mainstream models tell us.

One final point. The UK equivalent to these ‘official’ numbers are the OBR’s estimates of the impact of fiscal consolidation on the UK. While they are significant in size, they are smaller than these EZ numbers. The OBR estimate that UK GDP in 2013 is about 1.5% lower as a result of fiscal consolidation, and the cumulated GDP loss due to fiscal tightening from 2010 to 2013 is a bit above 5%. There is a good reason and a bad reason for this difference. First, the UK is a more open economy than the EZ as a whole, and we would expect openness to cushion the impact of fiscal consolidation. Second, the OBR’s numbers are more crudely derived, based on multipliers that take no account of the zero lower bound or deep recession. The numbers from the QUEST model allow for both, which of course raises the size of the fiscal impact.

[1] As the disclaimer says, “The views expressed are the author’s alone and do not necessarily correspond to those of the European Commission.” A good example of the official line is Buti and Carnot, but this line does not tend to be backed up by model simulations, which I think is revealing.